What next for UK inflation?

To help me plan my retirement what figure percentage should I use as the average annual rate of inflation over the next five years? K, Wakefield.

This is Money Editor Andrew Oxlade says: The future for inflation is the issue of the day, sparking frantic debates in web forums in recent months.

Many pensioners who are reliant on a fixed income from an annuity are concerned that today's low inflation may be under threat from the measures being deployed to end the recession - namely, the Bank of England's quantitative easing programme that has seen £200bn of newly created money pumped into the system. This QE plan basically increases the amount of money in existence and therefore the chances of inflation further down the line.

A large part of the reason for that programme is the fear of deflation. Some experts fear that the economies of the UK and other developed nations are so weak that falls in prices may move into a deflationary spiral. Deflation is already being registered in the US and the Eurozone.

Japan suffered this fate in the Nineties and early Noughties, with deflation's grip only loosened by a combination of the Bank of Japan's pioneering quantitative easing measures and rising demand from booming foreign markets.

Deflation effectively makes debts grow - a nightmare for most developed nations where both governments and consumers are sitting on record peacetime debts. A deflationary spiral - where consumers put off today's spending on the hope of cheaper prices tomorrow - could dramatically delay economic recovery.

The inflation worriers say China, India and emerging markets, which have fared far better in the Great Recession, are already pushing up demand even ahead of a recovery in the West. The cost of oil - up from a low of $33 a barrel a year ago to nearly $80 - and other commodities, such as copper, are soaring. This, they say, will result in price rises in the UK.

A further concern is that Governments, and their central banks, will be happy to allow a little inflation to try and erode those enormous debts. It's something that billionaire Warren Buffett, a legendary investor and the world's second richest man, has warned about.

Even putting that aside, some suggest the expansion of money in the economy via QE will already be enough to significantly build future inflation.

It's also worth noting that even just the raised expectation of inflation can lead to inflation. The Bank of England's website carries this analysis: 'When firms and employees negotiate wages and when companies set their prices, they often consider what inflation might be in the period ahead, say the next year. Expected inflation matters for wages and prices because future price rises reduce the amount of goods and services that today's wage settlement can buy. So, if inflation is expected to be high, employees might push for a higher wage increase.'

In November, inflation expectations for the coming year picked up to 2.1% from 2% in October, according to the monthly YouGov/Citi survey. Median inflation expectations for 5-10 years ahead rose to 3.3% from 3.2% in October after holding at 3% for several months.

However, others are labelling these people as 'inflation alarmists'. They cite the enormous economic headwinds facing Western nations - the huge cuts in public spending needed to reduce record debts, continuing paralysis in large parts of the banking system, the rapidly rising costs of ageing populations.

Some argue that these problems could temper demand - and therefore inflation - for a decade.

A technical measure of future inflation

One technical indicator of future inflation is the 'output gap'. It's effectively the difference between demand for, and supply of, goods and services. That gap is around 6% in the UK at present and 5% in the US. But the measure is controversial. Some economists say that 'true' GDP figures, which measures the supply of goods and services (economic activity), only emerge years later making today's output gap estimate unreliable.

Its the BoE's job to control inflation - to keep the consumer prices index between 1% and 2%. It was 1.5% in October, a rise from 1.1% in September. It has fallen from a high of 5.2% in September 2008.

Every three months, the BoE produces a quarterly inflation report, which gives an indication of what it expects for the economy over the coming years. It publishes a fan chart of predictions (below).
Its November report suggested a core forecast of CPI rising as high as 3% in the next few months - largely a result of the comparison with an exceptionally low oil price last December - before falling back to a little more than 1% for much of 2010 and not higher than 2% until after 2012.

However, there's no guarantee of accuracy in these forecasts. The Bank of England was criticised for being slow to spot the current crisis - only cutting the bank rate once the banking meltdown was in full-swing last October (although Bank Governor Mervyn King did warn repeatedly from 2004 onwards about soaring debt and over-priced property).

It's worth noting, in particular, the rise in the inflation forecast between the November and August reports.

That said, the BoE's analysis should be better than most. It poses the question on its website: 'What determines the expected rate of inflation?'. And it gives this answer:

'The simple answer is monetary policy and how much people believe in the ability and commitment of the authorities - the government and the central bank - to achieve their inflation objectives. People have to believe that there will be low inflation before they stop building expectations of high inflation into their decisions. The authorities have to demonstrate that they will not allow inflation to rise - that they will act to ensure demand does not rise too much ahead of output.'

So if you're confident in the BoE, follow the forecast.

The Bank expects consumer price inflation to average 1.85% in the final three months, implying it will be above the 2% target by December, and 2.71% in the first quarter. The average inflation rate over the next four years would be around 1.8% to 2%. Conveniently, that is pretty much bang on the BoE's 2% target.

Bond markets, on the other hand, are pricing in an expected inflation rate of 2.5% over the next five years.